Riding the market rollercoaster is one of the hardest skills to learn as a DIY investor because everyone can get jittery when the stock market moves in any direction but up.
Fear is one of the greatest risks to investors, which is instilled by events like the biggest JSE crash in history, and one of the largest in the world, when it lost 79% in value during the Great Depression.
However, dips are not uncommon and happen often, and not every change in direction signals the start of a crash.
When deciding what to do with your investments and trading positions, it is important to understand the difference between a crash, reversal and correction as they represent vastly different scenarios with different implications for your strategy.
A market correction
A stock market correction, also known as a “pullback” or “retracement” is generally defined as a temporary reversal in the movement of a stock price or an entire market, against its prevailing trend.
It is considered a natural and normal part of market cycles and typically refers to a decline of less than 10% from a recent high. Sometimes, it can be slightly more. For instance, a correction is often defined as a 10-20% drop, but the core idea is that it’s not a severe plunge.
Various factors can cause retracements, including, profit-taking, temporary shifts in investor sentiment, market consolidation, or technical factors, like when traders identify potential areas where prices might find support or resistance.
For example, the JSE ALSI dropped by approximately 12% between October 2017 and mid-January 2018. This JSE retracement happened largely due to a shift in investor sentiment caused by political uncertainty in the lead-up to the ANC elective conference.
You can identify a retracement or correction by the following characteristics:
- Temporary: This is the key distinguishing factor. A retracement is a short-lived deviation from the main trend. It’s not a fundamental change in the market’s direction. Short-lived, usually lasting from a few days, weeks, or sometimes months.
- Goes against the prevailing trend: If the market or a stock is generally moving in an uptrend, a retracement will be a temporary downward dip in price. If the market or a stock is generally moving downwards (a downtrend), a retracement will be a temporary upward bounce in price.
- Within a larger trend: The overall direction of the market or stock remains the same. After the retracement, the price is expected to resume its original trajectory.
A market reversal
A reversal is different from a retracement or correction in that it is a more significant and often longer-term change in the overall direction of the trend. A reversal indicates that the previous trend has ended and a new one has begun.
The 44.8% decline in the FTSE/JSE ALSI experienced over 143 days that occurred after the 1987 Black Monday crash is an example of a JSE reversal as South Africa entered a long recession due to economic sanctions.
You can identify a market reversal by the following characteristics:
- More sustained: Part of broader market cycles, not just short-term volatility. They tend to persist as the new trend builds momentum, which means they can last for months to years, depending on the cycle.
- Trend change: A clear shift from an uptrend to a downtrend, or downtrend to an uptrend. Higher highs and higher lows suddenly become lower highs and lower lows (or vice versa).
- Breaks in levels: When the market breaks below a well-established support level in an uptrend or above resistance in a downtrend, it can signal a reversal. These breaks often trigger technical selling or buying.
- Divergence with indicators: A reversal is often preceded by a divergence between price and momentum indicators like RSI or MACD.
A market crash
A stock market crash is a sudden, severe, and often unexpected collapse in stock prices across a significant portion of the market, indicating a major loss of investor confidence and often a change in the underlying economic landscape.
A crash is driven by more fundamental and systemic issues, like when speculative bubbles burst after asset prices become wildly inflated beyond their true value.
Major economic shocks, like the 2008 financial crisis, can also cause the market to crash. This bubble affected global markets and led to a JSE market crash, with the local bourse losing 22% from its previous highs by the end of September 2008, and experiencing a series of bad days, falling by about 30% in 2008.
Other major global events like pandemics, geopolitical crises like wars, and high inflation can also lead to a loss of investor confidence and panic selling that drives market crashes.
You can identify a market crash by the following characteristics:
- Magnitude: A sharp and substantial decline, typically defined as a drop of 10% or more in major indices within a single day or a very short period.
- Duration: While the initial plunge is rapid, the recovery can take months or even years. Crashes often precede or coincide with economic recessions.
- Context: Represents a significant break from the previous trend and can mark the beginning of a bear market.
Managing risk
Understanding the difference between a retracement, reversal and crash can help traders and investors avoid panicking and selling during temporary dips if they believe the overall trend is still intact.
In this regard, it is important to remember that a stock market retracement is a normal and often healthy fluctuation within a larger trend, indicating a temporary counter-movement in price before the original trend resumes.
